Analysis of Guillermo Furniture Store: Alternative Business Options - Case Study Example

Analysis of Guillermo Furniture Store: Alternative Business Options Introduction Guillermo has been operating in Sonora, Mexico for many years. The company has experienced relatively high levels of sales and profits over the years until the late 1990’s when it started to face competition from abroad. This competition led to a reduction in Guillermo’s profit levels. There are several things that Guillermo could do to reduce the threat arising from the competition; however, the company has chosen not to entertain options involving growth by way of mergers and acquisitions. Guillermo has instead set its eyes two options that require extensive analysis and evaluation before a decision can be made. These alternatives are: going hi-tech option and becoming a broker. The hi-tech solution is highly automated, uses vey little labor and uses robots. Additionally, it is able to operate on a 24 hour basis. The cost of utilizing this technology is very high and could only be facilitated if Guillermo can generate the required levels of sales to break-even. Tsorakidis et al (n.d., p. 2) indicates that break-even is the minimum level of sales that ensures that the company does not make a loss. The broker option involves becoming a local distributor or representative for a foreign company. This option would allow Guillermo to continue with some of the high-end custom jobs but the business would be become more of a distribution company rather than a manufacturing company. Like the hi-tech option it will involve some changes in the way Guillermo has been operating. This paper evaluates these two options along with the current situation, in order to determine if Guillermo should continue as is or use the more beneficial of the two options. This will involve the use of capital budgeting techniques. Cash flows analysis involving the very popular net present value (NPV) technique will be used to make a decision. Emery et al (2007) indicates that the value that a capital budgeting project creates is its NPV which is dependent on the cost of capital. Evaluation techniques When making capital budget decision a business should evaluate the expected future cash flows with respect to the initial investment required (Emery et al 2007). Guillermo’s main objective is to find the option that will generate the most return. Inclusive of the NPV which will be used in this analysis a number of other project evaluation techniques are available. They include the simple payback, the internal rate of return (IRR) and the Accounting Rate of Return. Net Present Value The NPV takes into consideration the time value of money. Cash flows are discounted at the cost of capital. If NPV is positive then the initial investment can be recovered from future cash flows. The project with the highest NPV is normally chosen. Simple Payback Period According to Jensen (2005) the payback period is the number of years required to equate the cost of the investment with the returns that it has generated. It is widely used because it is simple to calculate. It is used mainly as a preliminary technique to determine whether a project is viable. However, it does not take into consideration the time value of money which is a very important factor to consider when taking investment decisions. Additionally, it is biased towards short term projects and so the level of uncertainty increases when the project is lengthy. Accounting Rate of Return The accounting rate of return (ARR) employs a number of formulas in its calculation. The most widely used formula for calculating ARR is to divide the estimated average profits to be earned over the life of the project by estimated average investment and multiplying by 100 to obtain the percentage. Internal Rate of Return Brigham and Ehrhardt (2005) indicate that the internal rate of return (IRR) equates the present value of a project’s expected cash flows to the present value of its projected cost. Businesses prefer to ask whether the project offers a higher return than investors expect to earn by investing in the capital market rather than whether it yields a positive NPV (Brealey et al 2003). Return here is generally defined as a discount rate at which NPV is equal to zero and is usually attractive if it is higher than the opportunity cost of capital (Brealey et al 2003). The formula used to calculate the IRR is as follows: NPV = CF0 + ((CF1/(1 + IRR)1)1 + ((CF2/(1 + IRR)2) + (CF3/(1 + IRR)3) + (CF4/(1 + IRR)4) + (CF5/(1 + IRR)5) = 0. The formula indicates that the calculation of IRR involves the use of NPV. The IRR represent the rate of return when NPV is equal to zero The Cost of Capital The cost of capital has to be considered when making investment or capital budgeting decisions. According to Brigham and Ehrhardt (2005) most firms employ several types of capital and the required return on each component is required in the analysis of capital budgeting decisions. When this is done the resulting weighted average return is called the weighted average cost of capital (WACC). The formula for calculating WACC is: WACC = E/(D+E)re + D/(D+E) (1-T)rd = (1-L)re + L(1-T)rd E represents shareholders’ equity; D – debt; T - the tax rate; L – leverage; re is the cost of shareholders funds In order to calculate the cost of shareholders funds a number of components such as beta which represents the systematic risk and the risk free return which is generally the return on ten year bonds are required. Since Guillermo is not a publicly traded firm the beta is not available and therefore a 15% cost of capital will be used in the calculation of the NPV. Evaluation of Alternatives The alternatives available to Guillermo are to continue as is, invest in the hi-tech machine, or become a broker. Table 1 below shows cash flows based on current levels of operations. Calculation of Cash Flows Description Hi-tech Broker Continue Net Income before taxes 195,564 50955 42,577 Tax at 42% 82137 21401 17882 Net Income after tax 113,427 29554 24,695 Add back Dep 416,667 416,667 50,000 Cash Flow 530,094 446,221 74,695 Table 1 Table 1 shows the cash flows from the three scenarios. All cash flows are positive. However when these are discounted a different picture will result. The cost of capital that will be used to calculate the net present value of the projects is 15%. The options are analyzed in the following sections Continue as is If Guillermo continue as is net profit before tax of 42,577 pesos are more or less guaranteed as shown in Appendix 1. The company is projected to show positive cash flows of 74,695 after tax which represents 250,393 pesos in NPV terms over the next 5 years and 374,489 pesos over the next 10 years as shown in appendix 2. The company has sufficient working capital to pay its debts as they fall due. Table 2 indicates this. Working Capital Situation Liquidity Ratios Formula 2010 2009 Current ratio Current assets to current liabilities 3:1 3:1 Acid test ratio (Current assets – inventory) to current liabilities 2 2 Table 2 Table 2 indicates that the Guillermo has been able to pay its debts as they fall due for the past two years and should not have any major problems if it continues to do business in this fashion. However, if sales fell below 27% of the current level the company will start making losses. This, however, is not foreseen at this time and the company has sufficient excess profits to reduce cost by another 20%. Invest in Hi-Tech Machine If Guillermo chooses to invest in the hi-tech machine the company would have to invest a substantial amount of money. This amount can be derived based on the forecasted depreciation charge of 466,667 pesos, of which 50,000 pesos relate to the building that was purchased 13 years ago. This means that the balance of 416,667 pesos relates the hi-tech equipment. The table below provides the calculation of this information. Calculation: Cost of Hi-Tech Equipment Total Depreciation Charges 466,667 Less: Depreciation on Building 50,000 Depreciation on Hi-Tech Equipment 416,667 Multiplied by: Estimated Economic Life 10 Cost of Hi-Tech Equipment (416,667 x 10) 4,166,670 Table 3 Table 3 indicates that the cost of the hi-tech equipment is $4,166,670. The company does not have the necessary resources and so a loan will have to be obtained to cover the cost. This has not be taken into account in the income information in Appendix 1 and shown in Table 1 may need to be used to adjust the cash flow shown. Adjustments have been made for depreciation which does not represent a cash outflow. The NPV calculation in Appendix 2 indicates that Guillermo would have negative cash flows of 2,389,689 over a 5 year period and a negative 1,506,234 over a ten years period if this option is chosen. Become a Broker Based on the information presented the broker option would require an equipment costing the same amount as required for the hi-tech option. The returns and cash flows from this option as shown in Appendix 1 and Table 1 above respectively are substantially less than the hi-tech option. The NPV calculations show a negative 2,670,848 pesos over the five year period and a negative 1,927,176 over a ten year period. This suggests that this option cannot achieve positive cash flows in net present value terms over its estimated useful life. The Flame Retardant and the Coating Process The current cost for the flame retardant is 10 pesos per liter. Even though a market exists for the product the price is same as the cost. It would not be beneficial to the company to employ labor to produce the product and based on the amount required it would be best to purchase it. It cost Guillermo 25 pesos to produce the coating but it can be bought for 27.5 pesos. This is a difference of 2.5 pesos which represents 10% on Guillermo’s cost. There is no market for this product. Additionally, enough information is not provided in order to make a decision. I would suggest that Guillermo seriously considers buying this product. Conclusion The analysis indicates that the two alternatives considered – hi-tech and broker options have yielded negative results. Based on the information presented in Appendix 2 and the analysis of the figures, it is best for Guillermo to continue operating as it has been, until a more favorable alternative is found. The company should also consider buying the flame retardant and the coating since it makes more economic sense to do so. Appendix 1 Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,798.00 3,798.00 High-End 506.00 759.00 759.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,497 Benefits 103,730 82,412 21,644 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 82,137 21,401 265,282 891,543 663,663 222,705 695,979 612,708 42,577 195,564 50,955 Sales at 27% below Current levels Production Mid-Grade 1,884.00 High-End 377.00 Direct Materials ($)/Unit Mid-Grade 140.00 High-End 250.00 Direct Labor ($/HR)/Unit 15.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 High-End 30.00 Direct Cost/Unit Mid-Grade 440.00 High-End 700.00 Price/Unit Mid-Grade 509.00 High-End 879.00 Plant Overhead/Yr Salaries 50,000 Utilities 9,000 Benefits 78,485 Insurance 3,000 Property Taxes 975 Depreciation 50,000 Supplies 6,000 Income Tax Expense 8 197,479 197,460 19 Appendix 2 Continue as is   Year Cash Flow PV Factor 15% PV of Cash Flow NPV at 5 yrs 0 0 1 0   1 74695 0.8696 64955   2 74695 0.7561 56477   3 74695 0.6575 49112   4 74695 0.5718 42711   5 74695 0.4972 37138 250393 6 74695 0.4323 32291   7 74695 0.3759 28078   8 74695 0.3269 24418   9 74695 0.2843 21236   10 74695 0.2472 18465                       NPV     374879   Hi-Tech Option   Year Cash Flow PV Factor 15% PV of Cash Flow NPV at 5 yrs 0 (4166670) 1 (4166670)   1 530094 0.8696 460970   2 530094 0.7561 400804   3 530094 0.6575 348537   4 530094 0.5718 303108   5 530094 0.4972 263563 (2389689) 6 530094 0.4323 229160   7 530094 0.3759 199262   8 530094 0.3269 173288   9 530094 0.2843 150706   10 530094 0.2472 131039                       NPV     (1506234)     Broker Option   Year Cash Flow PV Factor 15% PV of Cash Flow NPV at 5 yrs 0 (4166670) 1 (4166670)   1 446221 0.8696 388034   2 446221 0.7561 337388   3 446221 0.6575 293390   4 446221 0.5718 255149   5 446221 0.4972 221861 (2670848) 6 446221 0.4323 192901   7 446221 0.3759 167734   8 446221 0.3269 145870   9 446221 0.2843 126861   10 446221 0.2472 110306                       NPV     (1927176)   References Brealey, Myers, Marcus, Maynes, and Mitra. (2003). Fundamentals of Corporate Finance. Retrieved on 22nd Aug from: http://highered.mcgraw-hill.com/sites/0070898669/student_view0/chapter6/chapter_summary.html Brigham, E.F. & Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western Emery, D.R., Finnerty, J.D. & Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall Jensen, P.A. (2005). Engineering Finance: Project Evaluation Selection. Retrieved on 22nd Aug from: http://www.me.utexas.edu/~me353/lessons/S2_Evaluation/L04_Selection/index.html Tsorakidis, N., Papadoulos, S., Zerres, M., and Zerres, C. Break-Even Analysis. Retrieved on 21st Aug from: http://bookboon.com/uk/textbooks/economics/break-even-analysis Read More